Henk Potts shops around for the best value retail stocks in 2010.

As Christmas approaches, investors’ minds will inevitably turn to the consumer discretionary sector. After all, Christmas is a crucial time for many of Britain’s favourite high street retailers, but, with unemployment rising and consumer credit tight, retailers need a message on price or a unique selling point to attract customers.

The recession produced a number of valuation anomalies in the consumer discretionary sector. We examine some of the most attractive opportunities below.

Driving through
One retailer that has caught our eye throughout the downturn is Halfords. Despite the government’s highly publicised car scrappage scheme, many families have opted to keep their existing cars on the road rather than choose a new model. This, in turn, has bolstered Halfords’ extremely profitable car maintenance activities.

The company also offers a good means of playing the increasing trend towards UK-based family holidays through its presence in bicycles and camping equipment.

Admittedly, the group’s top line has been constrained by lower sales of satellite navigation systems, alloys and other such ‘big ticket’ auto accessories, but car enhancement and not maintenance is actually a low-margin business for the firm. Halfords also represents an interesting means of hedging against tough new car markets in 2010 – something that could prove useful if unemployment continues to rise, as we expect.

Retailers of DIY and household goods have been among the worst hit in the downturn, and it was this that prompted us to review our recommendation on Home Retail Group, owner of Argos and Homebase.

Argos takes care of it
There are four key supports to our investment case for Home Retail Group. Firstly, its share price seems to be ascribing no value at all to the Homebase business, which seems extreme, even when the sharp slowdown in the housing market is considered. Secondly, Argos should enjoy strong market share gains from the capacity withdrawal in the UK. 

Thirdly, the company is operating at very depressed margins in 2009 and 2010 due to currency headwinds. However, margins should recover over the period to 2013, providing the main driver of our above-consensus estimates. Finally, we believe growth opportunities such as HomeStore&More could be additive to our forecasts.

Of course, some investors may prefer to focus on those retailers unencumbered by a high street store base, and here it is very hard to make a case against N Brown. The firm offers a very high return on capital for a retailer and also benefits from its focus on larger-sized and older customers. These segments have historically proven to be loyal customers, even in a downturn. However, the group’s global ambitions are still relatively young and we see these, alongside the ‘Simply Be’ catalogue for younger customers, as potential areas for forecast upside going forward.

Rating the retailers
TUI Travel – owner of First Choice Holidays and Thomson – has done an excellent job of cutting capacity ahead of falling demand in order to protect pricing.

Moreover, given the huge amount of capacity that has been withdrawn from the holiday industry in recent years, TUI should be in a very strong market position once the UK emerges from recession.

Finally, after a recent review, we have upgraded Debenhams. The stock is one of the cheapest in the sector, with a one-year forward price-to-earnings ratio of just 10.2 times on our 8p earnings per share estimate.

We would stress, however, that our positive view on Debenhams – and indeed the other retail names mentioned – should be seen in the context of our negative overall view on the European general retail sector and our expectation that the UK consumer will remain under some pressure in 2010.

Despite these caveats, we believe that Debenhams should be able to derive significant benefits from changes to its product mix. Specifically, the company has been focused on increasing its mix to own-bought products and away from concessions, so it can better control quality and value and thus improve margins and gross profit.

Over the longer term, we think Debenhams’ various initiatives (notably the push into multi-channel retailing, its focus on improving margins, the opening of smaller sites and delivering fashion rather than basics) will all drive shareholder value. The company has also improved its capital structure and we do not believe leverage is an issue. Earnings per share are likely to be down next year (due to an increased share count) but we expect profits before tax to be up by more than 20 per cent.

Henk Potts is equity strategist at Barclays Wealth